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News

Crude falls for 4th straight day on demand woes

News

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Will mighty Microsoft build on its 2024 gains?

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Learn

The Most Common Trend Reversal Patterns

Timely and correct identification of trend reversals can help traders enter positions at the right time or exit positions before the market moves against them.

Disclaimer: This article is an educational guide to CFD trading and the financial markets and should not be considered as advice. Trading CFDs is high risk. Always ensure you understand the potential risks and rewards associated with trading before you trade.

 

 

Accurately identifying reversals is the most critical skill to build for trend traders. Reversals are both the perfect entry and exit points. If you’re already trading a trend, the early identification of a reversal can help you lock in gains and prevent losses when the market changes direction. Since a reversal marks the beginning of a trend in the opposite direction, some traders may consider this as the right time to enter an asset and ride that direction in price movement. Here’s a look at the common trend reversal patterns, their timing, and how to identify them.

1. Things to Remember When Looking for Reversal Patterns

 

Identifying reversals is key to successful trend trading. Here are a few things to keep in mind to make the right decisions regarding your trade set-ups:

A. Reversals and Pullbacks are Different

There’s always some degree of volatility in the markets. However, not all price changes are reversals. Small countermoves against the trend could be pullbacks and may not indicate a trend reversal, which is what happens when the bulls or bears have lost control, causing a change in the direction of the market. Exiting on a pullback can reduce the returns from a winning trade. Studying historical charts will give you an idea of how the asset typically behaves and whether a price movement is a pullback or marks the beginning of a reversal.

Tip

Since the duration of a pullback is short, you may wait it out till a reversal takes hold.

 

B. Reversals Can Occur in Different Timeframes

Reversals can occur during the span of a day, and even over weeks or months. These reversals are relevant to different traders. If you’re a long-term trader, reversals in a single day may not matter to you. If you’re an intraday or day trader, reversals in the minute or hourly charts will be important.

 

C. Candlestick Charts are Best for Identifying Reversals

Given that candlestick charts convey much more about the market, they allow you to identify reversals and extensions more accurately than other chart types. This is why algorithmic trading also uses these to spot signals.

 

2. Reversal Patterns Every Trader Should Know

 

Some popular candlestick reversal patterns are:

 

A. Head and Shoulders

This unique reversal pattern is created by three peaks of the price. The two peaks on the sides are usually of similar height (known as shoulders), while the one in the middle is the highest (known as head). This pattern is used after a significant uptrend, while the opposite head and shoulder is used after a downtrend.

Once a head and shoulder pattern is formed, the three bottoms of the three peaks are joined together to form a neckline. The moment the price breaks this neckline, it is considered as a reversal signal. You can take a sell position after an uptrend or go long after a downtrend.

Tip

While most traders place their stop loss above the right shoulder when an uptrend reverses, experienced traders calculate the stop loss based on the pips of the last swing high.

 

B. Triple Tops and Bottoms

During an uptrend, if three peaks are formed that are almost the same height, it is considered a sign of reversal. This formation indicates that the buyers may be running out of steam. When this happens, you need to keep an eye on the trigger line, which is the last bottom between the second and third peaks. The price breaching the trigger line is an indicator to go short.

Similarly, during a downtrend, three bottoms forming indicates that bears are losing power. When the price breaks out of the trigger line, which is the top between the last two bottoms, you can consider opening a buy position.

 

C. Hammer

The occurrence of a pin bar or hammer in a downtrend signals the start of a rally. Similarly, the occurrence of an upside-down hammer, known as the shooting star, during an uptrend signals a potential reversal to the downside.

 

D. Engulfing Candlesticks

A bullish engulfing candlestick indicates a possible reversal of an uptrend. This is a bullish candlestick that has a close higher than the open and completely encompasses the body of the preceding down candlestick. The bearish engulfing candlestick signals the beginning of a rally in the market.

Tip

You can enter a position after the engulfing candlestick has closed while placing the stop loss below the low of the engulfing candlestick.

 

E. Sushi Roll

This pattern, identified by Mark Fisher in his book The Logical Trader, provides an early signal of a possible change in trend. The main feature is that it comprises multiple (usually ten) bars in which the first five are confined in a narrow range of highs and lows, while the latter five engulf the former with a higher high and lower low. The first five bars are known as “inside” bars and the latter ones are known as “outside” bars.

The pattern is similar to engulfing candlesticks but comprises of many more bars. If this pattern appears in a downtrend, it is considered a signal to go long or exit a short position. If the pattern becomes visible in an uptrend, you can consider selling a long position or entering a short position.

Longer-term traders can use daily data of a trading week. The pattern occurs when an inside week is followed by an outside week, or engulfing week, comprising of higher highs and lower lows.

Tip

Patterns are powerful signals of trend reversal. However, they can produce false signs and must be used in combination with other tools for better predictions.

Key Takeaways

  • Trend reversals provide attractive entry and exit points.
  • Identifying reversals is key to successful trend trading.
  • Reversals are different from pullbacks and distinguishing between the two is important.
  • Consider reversals in the timeframe that suits your trading style.
  • Head and shoulders, triple tops and bottoms, hammer, engulfing candlesticks, and sushi roll are among the most common patterns used by traders.

 

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